Many of the problems economies face cannot be solved by easy money. They are structural, so can only be remediated through adjustments to economic arrangements, such as taxation, competition, industry and trade policy.
Over the past two decades there has been a loss of perspective about what monetary policy can and cannot achieve. It is a tool to impact on demand in the economy in the short term. It cannot impact on demand over the long run nor can it influence the supply side of the economy – at least, not in a positive manner.
One of the most worrying features of the world economy has been persistently weak productivity growth in many advanced economies. This apparent secular stagnation is characterised by a loss of economic dynamism, weak real wage growth and low consumer price inflation. Yet asset prices and debt levels are surging higher.
Inflation has become insensitive to monetary policy over the past 15 years, largely due to technological innovation. Despite this, central banks remain as sensitive to inflation as ever.
Easy monetary policies distort private sector decision making and ultimately reduce the productivity and efficiency of the economy.
Economies are dynamic and in a constant state of adjustment to changes in technology, preferences and regulation. While it may be desirable to smooth these transitions of labour and capital, central banks should be careful not to hobble the pace of change – or halt the process altogether.
Central banks should be careful not to hobble the pace of change – or halt the process altogether.
The damage being wrought by the worst perpetrators of super-easy monetary policies – such as the Bank of Japan and the European Central Bank – is not confined to their own economies, but drags others with them via the effects of capital outflows and currency depreciation.
Central banks like the RBA are forced to respond to tightening financial conditions in their own economies as foreign central bank stimulus drives their own currency higher. This appears to be the primary motive for a further easing from the RBA next week; to reduce upward pressure on the Australian dollar.
The conduct of monetary policy has created a policy inaction bias in many countries. Central banks have let governments off the hook on politically difficulty fiscal and structural policies by boosting spending in the short term, potentially at the expense of economic activity down the track.
The real question is whether in their attempts to solve the world’s problems, central bankers have inadvertently created bigger problems for themselves and the communities they serve.
A real concern is that the magnitude of the economic and financial shock of 2020 may reveal some of the vulnerabilities created by the persistently easy monetary policies of the past decade.
The costs of excessively easy monetary policy are mounting despite consumer price inflation remaining stubbornly low.
- Financial instability. Easy money and low interest rates put upward pressure on asset prices and debt levels. Holding the cost of money below its market rate for extended periods can encourage financial speculation and a misallocation of resources, creating vulnerabilities to negative shocks within the economy and financial system.
Financial instability is now a well-accepted cost of easy monetary policy and is managed by policymakers through other policy tools; such as prudential regulation and oversight. In 2021, when bank moratoriums are lifted, we will have a much better insight globally into how effective these other policies have been at managing the financial instability consequences of easy money.
- Pushing financing activity outside of the core regulated financial system. Savers are seeking “yield” in unregulated and risky parts of the shadow financial system or they are cashing out altogether. It should not be underestimated how important to Australia economic success has been the role of a stable and well-regulated financial system.
- Economic efficiency. Low interest rates can allow financially weak firms to survive for longer than otherwise would be the case, the so-called zombies. A critical element of the efficient allocation of capital in the economy is the extraction of capital (and labour) from businesses and industries in decline. Progressively easier monetary policy saps the vitality of a market economy. With the size of the economic shock in 2020, many advanced economies may be carrying a much larger number of financial weak firms into this downturn than has previously been the case.
More and more evidence is building of hidden costs to easy money that take time to reveal themselves. It remains to be seen how costly these “hidden costs” will be. It may also be that excessively easy policy has plunged economies into a form of liquidity trap which they cannot extract themselves from without costly economic and financial restructuring.
While the RBA has avoided the worst excesses of the large central banks, their resistance appears to be crumbling in recent months as officials publicly ponder the merits of further monetary stimulus through unconventional means.